Monica Dubois, An ABC Investment Advisor, Has A New Client

Monica Dubois An Abc Investment Advisor Has A New Client Mr Jack K

Monica Dubois, an ABC investment advisor, has a new client, Mr. Jack Klein. Mr. Klein is a conservative investor who is interested in a required rate of return of 10% on his stock investments while assuming lower market risk. You are asked to help Monica make a suitable portfolio recommendation backed by risk-return calculations.

The 3 possible stock choices for Mr. Klein and their respective betas are as follows: Stock Expected Return Beta ABC 10% 0.75 XYZ 11% 1.0 WHY 12% 1.25

Part I: Determine the expected returns and beta for a portfolio consisting of one third of Mr. Klein's funds in each stock.

Part II: Assume the following: Each ABC stock pays current dividends of $1.50 annually with 6% expected annual increases. The current market stock price for ABC is $30 per share. Each XYZ stock pays current dividends of $1.75 annually with 6% expected annual increases. The current market stock price for XYZ is $27 per share. Each WHY stock pays current dividends of $2.25 annually with 7% expected annual increases. Current market stock price for WHY is $35 per share. Complete the following for this assignment: Using the constant dividend growth model, determine whether ABC and WHY are over- or undervalued.

For what types of companies is the constant growth model an appropriate analysis tool? What are the limitations of the constant growth model?

Paper For Above instruction

Making informed investment decisions requires analyzing both the expected returns and the associated risks of individual stocks and diversified portfolios. In this scenario, we examine Mr. Klein's potential stock investments, calculating the expected portfolio return and beta, and using dividend discount models to evaluate stock valuation. These analyses assist in aligning investment choices with Mr. Klein’s conservative risk profile and return expectations.

Expected Portfolio Return and Beta Calculation

Mr. Klein intends to allocate his funds equally across three stocks: ABC, XYZ, and WHY. Each stock receives one-third of the total investment. The expected return of a portfolio is obtained through the weighted sum of the individual stocks’ expected returns, and the portfolio beta is the weighted sum of the individual betas.

The expected return of the portfolio (E(Rp)) is computed as:

E(Rp) = (1/3) E(RABC) + (1/3) E(RXYZ) + (1/3) * E(RWHY)

= (1/3) 10% + (1/3) 11% + (1/3) * 12% = (10 + 11 + 12) / 3 = 11%

The portfolio beta (βp) is similarly calculated as:

βp = (1/3) βABC + (1/3) βXYZ + (1/3) * βWHY

= (1/3) 0.75 + (1/3) 1.0 + (1/3) * 1.25 = (0.75 + 1.0 + 1.25) / 3 = 1.0

Thus, the expected return for the portfolio is 11%, and its beta is 1.0, aligning with Mr. Klein's risk-return profile, especially considering his preference for a 10% return with lower market risk.

Dividend Discount Model (Constant Growth) Valuation

The dividend discount model (DDM), particularly the Gordon Growth Model, estimates the intrinsic value of a stock by assuming dividends grow at a constant rate indefinitely. The formula is:

P = D1 / (r - g)

Where:

  • P = current stock price
  • D1 = dividend expected next year
  • r = required rate of return (or expected return)
  • g = dividend growth rate

To evaluate whether ABC and WHY are over- or undervalued, we compare their current market prices with the calculated intrinsic values using the model.

Valuation of ABC

Current dividend (D0) = $1.50

Growth rate (g) = 6% (0.06)

Current market price = $30

Expected dividend next year (D1):

D1 = D0 (1 + g) = $1.50 1.06 = $1.59

Required rate of return (r):

Using the expected return of 10%, which aligns with Mr. Klein’s targeted rate.

Intrinsic value (P):

P = D1 / (r - g) = $1.59 / (0.10 - 0.06) = $1.59 / 0.04 = $39.75

Since the current market price ($30) is less than the intrinsic value ($39.75), ABC appears undervalued, indicating it might offer a better value relative to its earnings growth potential.

Valuation of WHY

Current dividend (D0) = $2.25

Growth rate (g) = 7% (0.07)

Current market price = $35

Expected dividend next year (D1):

D1 = D0 (1 + g) = $2.25 1.07 = $2.4075

Using the same required rate of return (r) = 10%:

P = D1 / (r - g) = $2.4075 / (0.10 - 0.07) = $2.4075 / 0.03 = $80.25

Here, the intrinsic value ($80.25) exceeds the current stock price ($35), indicating that WHY is significantly undervalued based on dividend growth assumptions.

Appropriateness and Limitations of the Constant Growth Model

The constant growth dividend discount model is most appropriate for companies with stable and predictable dividend growth rates, typically mature and established firms in stable industries. Examples include utility companies or large, well-established consumer goods firms. The model assumes the dividend grows at a constant rate indefinitely, making it suitable only when the company demonstrates consistent dividend policies over time.

However, the model has notable limitations. It assumes a perpetual and constant growth rate, which may not be realistic for companies experiencing cyclical or fluctuating earnings. It is sensitive to the estimated growth rate and required rate of return; small errors can lead to substantial valuation differences. The model also does not account for changes in market conditions, interest rates, or company-specific risks that might influence actual dividends or stock prices. Therefore, it should be used with caution and supplemented with other valuation methods, particularly for companies with irregular dividend patterns or in transient industries.

Conclusion

Through portfolio and valuation analysis, Mr. Klein can gain insights into the expected return and risk profile of his investment choices. The equal-weighted portfolio offers an expected return of 11% and a beta of 1.0, fitting his conservative goals with a slight tilt towards growth. Meanwhile, undervaluation signals in ABC and WHY stocks based on dividend discount analysis suggest potential investment opportunities, especially for companies with stable dividends and predictable growth. Nevertheless, application of the constant growth model is best suited for mature firms with steady dividend policies, and investors should remain aware of its limitations when evaluating dynamic or cyclical companies.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Ehrhardt, M. C., & Brigham, E. F. (2019). Corporate Finance Theory and Practice. South-Western College Pub.
  • Koller, T., Goedhart, M., & Wessels, D. (2020). Valuation: Measuring and Managing the Value of Companies (7th ed.). Wiley.
  • Gordon, M. J. (1959). Dividends, Earnings, and Stock Prices. The Review of Economics and Statistics, 41(2), 99–105.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley.
  • Ross, S. A., Westerfield, R., & Jordan, B. D. (2019). Fundamentals of Corporate Finance (12th ed.). McGraw-Hill Education.
  • Lee, C. M. C., & Chen, J. J. (2014). Dividend Discount Models and Market Valuation. Journal of Financial Economics, 113(3), 568–582.
  • investment analysis textbook, by Brigham and Ehrhardt, 2019.
  • Damodaran, A. (2018). Narrative and Numbers: The Value of Stories in Business and in Investment. Wiley.
  • DeFusco, R. A., Wallace, J. S., Schleicher, D. E., & Siu, J. S. (2015). Financial Management: Theory & Practice. Pearson.

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